Calls to attach strings to central banks’ liquidity

CENTRAL banks risk introducing moral hazard by providing liquidity to banks unconditionally, according to a report out last night from the Committee on the Global Financial System (CGFS), a part of the Bank for International Settlements (BIS).

The European Central Bank (ECB), now led by Mario Draghi (pictured right) has been a major provider of liquidity to troubled banks since the start of the financial crisis.

If such banks believe they will always be provided with foreign currency liquidity by central banks in times of crisis, this “could cause an unwelcome delay in needed domestic adjustments and in reducing existing imbalances,” the report said.

This expectation of help could “fuel risk-taking and tempt banks and other financial institutions to run larger currency and maturity mismatches”.

The report cites the International Monetary Fund’s (IMF) aid model as an example of one which attaches strings to any assistance, partly eliminating the risk of moral hazard arising.

“IMF conditionality has been instrumental in containing moral hazard,” the CGFS report argued.

Aid to governments from the IMF tends to be conditional on various structural changes being implemented, to avoid countries taking aid during a crisis and doing nothing to prevent another such crisis from occurring.

For example, the Greek government must cut back on its public spending and regain competitiveness with wage and pension freezes if it wants to receive bailout loans from the IMF.

However, overall the report claimed central banks performed well in addressing recent liquidity crises.

Thanks to the co-operation mechanism of the Basel process, the report said “central banks remain well placed to address future surges and shortages in global liquidity.”

Meanwhile, Bundesbank president Jens Weidmann yesterday argued against ECB intervention in bond markets, claiming it should not be “a lender of last resort for sovereigns.”

This would violate treaty agreements and undermine Eurozone stability, he told the FT.